Understanding the Canadian Mortgage Stress Test Changes in 2021
Meeting the criteria for a mortgage and getting accepted can be hard enough, but some people, particularly first-time buyers, fear that getting a mortgage in 2021 will be even more difficult in Canada due to the recent changes in the mortgage stress test.
Starting in 2018, all Canadian buyers applying for a mortgage from a federally regulated lender, including those who put down at least 20%, are required to take the OSFI Mortgage Stress Test. And as of June 1, 2021, the stress test has become more difficult.
This can have a significant impact on homeowner expectations, as their finances are evaluated even more rigorously before receiving mortgage approval. Borrowers must basically demonstrate their ability to make mortgage payments, even when interest rates rise.
So, in 2021 and beyond, how will Canadians deal with the mortgage stress test? And how will the stress test remain a part of the home-buying process in the future? Let's take a closer look at the new mortgage rules and how they will affect home buyers in 2021.
The Mortgage Stress Test Explained
A stress test is exactly what it sounds like from a financial standpoint. It's a way of seeing how you and your finances might do in the event of an unexpected financial setback, such as losing your job. When it comes to mortgages, it's about how you, as a potential homeowner, would handle your mortgage payments if your interest rate rose or you experienced a comparable financial emergency.
Simply put, the mortgage stress test pushes you to confront the significant expenditures associated with becoming a homeowner. As a result, all potential homeowners now have to demonstrate that they can afford their mortgages based on their lender's minimum "qualifying rate."
To pass the mortgage stress test after June 1, 2021, you must qualify at your contracted mortgage interest rate plus 2% or 5.25 percent, which is the benchmark rate (or floor) used to qualify uninsured and insured mortgages. If you apply for a mortgage at 3.65%, your lender will evaluate you as if you were paying your house loan at 5.65% (3.65% + 2%), because 5.65% is higher than the benchmark rate.
Because they are only eligible for a smaller loan amount at the mortgage stress-tested rates, some new homebuyers have had their purchasing power slashed by as much as 20% as a result of this stress test. Current homeowners have also found it more difficult to refinance or renew their mortgages as a result of the new stress test criteria.
Why Does the Mortgage Stress Test Exist?
Essentially, the stress test was created to address Canada's household debt problem and prevent consumers from accumulating even more debt by taking on a mortgage that was too large for them. In reality, the average Canadian household is in debt for 170 percent of their disposable income, meaning that for every dollar earned after taxes, Canadians owe $1.70. Many would-be homeowners would be unable to purchase their homes in the coming years due to the progressive rise of housing and interest rates across the country.
In July 2016, the Office of the Superintendent of Financial Institutions Canada (OSFI) proposed certain adjustments to Canadian mortgage and housing rules in a bid to reduce the country's household debt problem. One of them was the establishment of a new obligatory "stress test" for potential homeowners borrowing from federally regulated lenders like banks.
Initially, the criteria only applied to people applying for high-ratio mortgages, or those who didn't put down more than 20% and were thus subject to mortgage default insurance costs. Homeowners intending to take on a mortgage term of less than 5 years were also included in the test requirement.
All candidates, even those applying for conventional uninsured mortgages (greater than a 20% down payment), must take the test as of October 17th, 2017.
How to Prepare for a Mortgage Stress Test
There isn't much you can do about the difference between the benchmark rate and the rate your lender charges you, but knowing where you stand before applying for a mortgage can help. You should also speak with a mortgage broker or an experienced local real estate agent if possible.
Lenders look at a few important measures to see if borrowers can pass the stress test and keep up with their mortgage payments, such as the gross debt service ratio (GDS) and total debt service ratio (TDS).
Gross Debt Service Ratio (GDS)
Your GDS is the proportion of your pre-tax income that must be used to cover all of your housing expenses. Your lender will consider all of your monthly housing expenses, including condo fees (if applicable), utility bills, and property taxes, in addition to your stress-tested monthly mortgage payment.
All these expenses will be tallied up and divided by your monthly gross revenue. In an ideal situation, lenders would like to see a percentage of no more than 32%.
Total Debt Service Ratio (TDS)
All of your debts will have to be taken into account, which is why lenders will look at your TDS as well. This is the percentage of your monthly income that is required to pay off the rest of your non housing related financial obligations.
Car payments, personal loans, student loans, credit cards, lines of credit, and other debts fall into this category. To be accepted, your TDS should not exceed 42 percent of your gross monthly pay when all of these factors are considered.
Consider taking the following steps to better prepare for the stress test:
Reduce Your Debt
As previously stated, your lender will take into account all of your present debt when determining whether you are qualified for a mortgage. Your TDS will be lower if your existing debt load is smaller. As a result, your mortgage stress test results may be better. To avoid spending so much in interest charges, prioritize paying down your high-interest debt (such as credit cards).
Apply for a Smaller Loan
Be honest with yourself about how much house you can really afford.
You may have your heart set on a property in the $800,000 price bracket, but if you look at properties in the $600,000 price range instead, you may find yourself in a much more financially realistic situation.
This will not only improve your chances of passing the stress test and securing a mortgage, but it will also free up more of your income and keep you from being house poor.
Before you even apply for a mortgage, speak with a local real estate agent about just what properties are available in the lower price range you are considering.
Crunch Some Numbers
Consider if you could truly afford to pay an extra $500 in mortgage payments, for example, if rates rise after you've been accepted. This is particularly true for people who have a variable rate mortgage. Because variable rates are set by the prime rate, if you have one, a hike in general interest rates will have an immediate impact on your mortgage.
So, you might be fine with making $1,000 monthly mortgage payments, but what if you had to contribute an extra $500? Is it something you could do? Or would you be thrown into a financial tizzy as a result?
That is precisely why this stress test was put in place. Should interest rates rise in the near future, your lender will want to be sure you can still make all of your payments on time each month to avoid defaulting.
Is It Possible To Avoid The Mortgage Stress Test?
The stress test is intended for banks that are controlled by the federal government. However, some mortgage lenders are exempt from OSFI's supervision, such as private lenders or lenders regulated at the provincial level. As a result, unlike traditional banks and other federally regulated lenders, these lenders are not obligated to put their mortgage applicants through these stress tests.
Alternative subprime loans may be a realistic choice for you if you're one of the potential homeowners who may struggle on a mortgage stress test. However, it's vital to keep in mind that most alternative lenders charge higher interest rates than traditional lenders. Indeed, as a result of the new housing legislation, alternative lenders are now able to demand even higher fees for their services.
So, while a non-traditional lender may make it easier for you to qualify, keep these factors in mind before applying, since it may end up costing you more in the long run.
The Future of the Mortgage Stress Test
Many applicants have already tasted the wrath of the mortgage stress test's strict criteria, and their home purchasing power has been curtailed.
As a result, the mortgage stress test standards have been scrutinized extensively over the last year, and the OSFI is under increasing pressure to relax the rules.
While the rules were intended to ensure that borrowers did not increase their risk of failing and to slow down the housing market in order to reduce surging prices, critics argue that they are just too harsh.
Markets have calmed a little since the new stress test guidelines were implemented, and interest rates have begun to increase. As a result, the OSFI has decided to revisit the guidelines governing the stress test.
What does this mean for borrowers in the years ahead, starting in 2021? While the OSFI has indicated that it has no plans to amend the rules at the moment, only time will tell if this will change before 2022.
Looking to buy a home in the Waterloo Region but need to find out more about pricing and inventory, or have questions about how the mortgage stress test might affect your plans? Team Pinto will be happy to speak to you and discuss your options. Contact the award-winning Team Pinto here, or book a free Zoom consultation to discuss your unique Waterloo Region real estate needs 'face to face'.